Gold's Relationship With US Currency and Stocks

The short-term correlation between the metals and the USD Index is negative at this time and has been very weak recently.

According to CNBC, the recent volatility in gold prices has left not only investors and traders puzzled about what is going on with the precious metal.

"Nobody really understands gold prices and I don't pretend to understand them either," Federal Reserve chief Ben Bernanke told the Senate Banking Committee on Thursday in response to a question on why gold prices have been volatile.

Today, gold climbed up over $1,322 per ounce after the US dollar slipped against other currencies. It is the yellow metal's highest level since June 20. In this way, gold broke above a key technical level at $1,300. That level had been tested a few times in the last one-and-half weeks, and after today's breakout, investors are probably wondering what to do next. Can we find any guidance in the charts?

In today's essay, I'll examine other markets to see if there's anything on the horizon that could drive gold prices higher or lower shortly. Let's start with the USD Index very long-term chart. (Charts courtesy of http://stockcharts.com.)

The situation in the long-term chart hasn't changed recently. The breakout above the declining support/resistance line (currently close to 79) has not been invalidated. Therefore, the situation remains bullish.

Now, let's zoom in on our picture of the USD Index and see the medium-term chart.

On the weekly USD Index chart, we see that the recent declines didn't take the index below 82, so the medium-term uptrend is not threatened. The reason is that the medium-term support line was not broken; it was not even reached. From this perspective, the situation remains bullish and my firm expects the dollar to strengthen further in the coming weeks.

Let's check if the short-time outlook is also bullish.

From the short-term perspective, we see that the USD Index dropped last week, but it hasn't declined below the 61.8% Fibonacci retracement level based on the June - July rally. Despite the dollar increase after Ben Bernanke's testimony, the US currency slipped against other currencies once again in the recent days. Although the dollar declined below the Wednesday's intraday low at 82.47 today, the 61.8% Fibonacci retracement level close to 82.20 is still valid and serves as support.

If the buyers manage to push the USD Index higher, we might see an increase to the June top or even to the rising resistance line based on the May high and June peak before another pause is seen. However, taking a look at the long-term charts, we see that the next significant resistance is currently close to 86 (86.4) -- the declining red line.

Consequently, from the short-term perspective, the recent decline still seems to be a countertrend bounce. It means that we could see another rally soon, especially when we factor in the cyclical turning point, which is just around the corner. Taking a look at medium-term and long-term charts, both outlooks for the dollar remain bullish. This is a bearish piece of information for metals and miners.

Once we know the current situation in the US currency, let's find out what happened during the last several days and check the current situation in stocks. To begin, let's take a look at the long-term S&P 500 (INDEXSP:.INX) chart.

Click to enlarge

In recent days, stocks moved up once again and broke above the May top. At this moment, the breakout is still not invalidated, but from this perspective, we see that the recent decline was likely nothing more than another correction and the outlook continues to be bullish.

We would prefer to see two more weekly closes before saying that another upswing is very probable. It is likely at this time but not to any great extent.

Let's check if the short-time outlook is also bullish.

During the past week, the S&P 500 has continued its rally as expected. Prices climbed up to new historical highs on Thursday. The S&P 500 gained 0.5%, after reaching a daily high at 1,693.12. The breakout above the May 22 local top is a positive sign, but some short-term uncertainty cannot be excluded here.

Let us move on to the financial sector, which often leads the general stock market, for more clues regarding the future moves of the S&P 500.

On the above Broker-Dealer index chart, we see that last week's breakout is still not invalidated. The situation improved a bit (it's closer to being verified), and the outlook is a bit more bullish.

The situation for stocks in the medium term is still quite bullish although it's a bit uncertain in the short term. It seems that we could see further gains in the stock market, but then again, a consolidation could be seen first. It might seem that gold started to trade along with the stock market and the bullish implications are already resulting in higher prices of the yellow metal.

Now that we know the current situation in the dollar, the stock market, and the financial sector, let's take a look at the Correlation Matrix. This is a tool that we have developed to analyze the impact of the currency markets and the general stock market upon the precious metals sector (namely gold correlations and silver correlations).

The short-term correlation between the metals and the USD Index is negative at this time and has been very weak recently. Gold started to respond to the dollar's price moves (up when the dollar declined and down when the dollar rose), but we feel that was just a temporary phenomenon and the metals will likely continue underperforming.

All in all, with a bullish outlook for the dollar and regardless of whether the negative correlations between the metals and the dollar persist or not, the overall implications for the precious metals are bearish.

Summing up, the USD Index corrected almost to the final 61.8% Fibonacci retracement level but didn't decline below it. If the buyers manage to push the USD Index higher, we might see another rally soon. This is in tune with the medium-term and long-term trends and also with dollar's cyclical turning point. The implications are bearish for the precious metals sector.

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